Government Accountability Office: IRS Could Tax 'Virtual Currencies'

A new report from the Government Accountability Office (GAO) warns that the Internal Revenue Service should do more to warn taxpayers that they could have some tax liability over their holdings in Internet-based “virtual currencies” like Linden Dollars or Bitcoins.

“Transactions within virtual economies or using virtual currencies could produce taxable income in various ways, depending on the facts and circumstances of each transaction,” the report warns.

The GAO points out that online currencies that exist only within a certain program–like the “cash” used to buy weapons and items in video games–are not taxable if those currencies exist solely within their lone environment. But other online, “virtual currencies” are a bit less “virtual” in that they can be traded offline and used to purchase real things or can even be converted to U.S. dollars using various third party trading systems.

The latter, the GAO report states, could “pose various tax compliance risks.”

But there might be other worries in store for virtual currency users, things that are worse than merely paying taxes on the income, real or imagined, of virtual currencies. That worry is real-life crime.

In the same week in May that the GAO released its report, the Department of Homeland Security shut down a virtual currency trading service called Mt. Gox to prevent its trading in Bitcoins.

On May 14, DHS cut off links between the currency trading service Dwolla and Mt. Gox and put an end to the latter’s trading in Bitcoins. DHS even froze Mt. Gox’s assets. The reason DHS made this move is to prevent international drug dealers from doing business in Bitcoins; the online currency is often later turned into real-world currencies, including U.S. dollars.

Using a “confidential informant,” DHS explained how Mt. Gox and Bitcoins are used for criminal purposes.

Mt. Gox acts as a digital currency exchange where customers open accounts and fund the respective accounts with fiat currency, which is then exchanged into crypto-currency by Mt. Gox; the crypto-currency is known as bitcoin. Fiat currency simply refers to any money that a government has declared to be legal tender. The exchange is bidirectional and allows customers to also exchange bitcoins back into fiat currency, and then withdraw those funds. The exchange of fiat currency and bitcoins incurs a floating rate fee charged by Mt. Gox and is determined by the customer’s aggregate amount of funds exchanged on a monthly basis.

For years, virtual currencies have been promoted as a new world order, currencies that are above the normal world of laws, taxes, and national borders. But it appears that with the IRS looking at ways to tax them and security agencies looking for ways to stop terrorists and drug dealers from profiting from them, that notion that virtual currencies are above the law is no longer as axiomatic as proponents have claimed.